technical analysis
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technical analysis

Technical analysis (‘TA’) in its most basic definition is the study of action in markets to forecast future trends and prices. Traders use technical analysis as part of their efforts to determine whether and when to buy or sell. They also use it to decide when to exit their trades.

The core belief underpinning TA is that the current price of an instrument reflects all of the information available to those who participate in that market. Technicians believe that histories of prices and volumes of trades are indicators of how supply and demand change over time.

TA has a very long history. What we might now call technical analysis began in Japan in the 18th century. Traders in this period used what we know today as candlestick charts to track movements in the price of rice. An exceptionally wide range of diverse techniques in TA was developed in the late 19th and early to mid 20th centuries by, among others, Charles Dow, Ralph N Elliott, William D Gann, George Lane and Bill Williams.

Trends and technical analysis

Life in general often moves in trends. If somebody usually wakes up at 6.30, walks to the station and takes the train at 7.30 to work, they’re probably going to keep doing that unless there’s some notable reason for them to stop.

technical analysis

Financial markets are similar in this respect: trends usually continue unless there’s a clear indication that they’ll stop. ‘The trend is your friend’ is a bit of a cliché, but it’s a handy tip for new traders. Trading with the trend is almost always less risky than trading against the trend.

There are three types of trend relevant for traders:

  • Upward trends or uptrends

An uptrend features consistently higher highs and higher lows. On a chart, you’ll see a line or series of candlesticks moving upward from the left to the right over time.

  • Downward trends or downtrends

The opposite of an uptrend, a downtrend means consistently lower highs and lower lows. Charts display this with candlesticks going down from the left to the right over time.

  • Sideways trends or trading ranges

Sideways trends are trends without any overall direction. On charts this looks like price is ‘stuck between invisible walls’ as traders often say. Support and resistance (discussed below) are usually important for this type of trend.

trends in forex

This four-hour chart of USDJPY features short examples of each main type of trend. Click on the image to enlarge.

On the left there’s a downtrend marked by the red line. Then there’s an uptrend denoted with the pale blue line. Finally there’s a sideways trend demarcated with the two bright green lines. In practice, traders would usually talk about more extended movements than these being trends. Short directions are usually known as ‘movements’ or ‘waves’ or other similar terms.

Reading charts

 

Analysing charts usually focusses on identifying trends. These could be trends over the short-, medium- or long-term. Technical traders aim to identify areas where supply and demand have reached equilibrium in the past. They also try to assess the likelihood of trends continuing, ending or reversing.

A core principle of TA is that any healthy trend features pullbacks. This means that the price of an instrument will not normally keep moving constantly in one direction. Instead, it’ll typically pause and consolidate after a main movement of two or three days. The angle of this consolidation is very important.

An acute angle, i.e. less than 90 degrees, can suggest that the trend is losing strength and might come to an end. This is often called a pullback but also a ‘correction’ or a ‘retracement’ instead of a consolidation. Conversely, an obtuse angle, in other words more than 90 degrees, often means that the trend might continue. Combining the study of these basic angles of consolidations with the number of new lows or highs is a much better way to trade than ‘oh this looks like a downtrend let’s sell’.

technical analysis

This four-hour chart of GBPNOK features an example of a pullback. Click on the image to enlarge. The first blue line outlines the upward trend. Then the arrow marks when the pullback begins. The angle between the two blue lines is less than 90 degrees, so technicians would typically expect that a reversal of the trend might be a favourable scenario here.

Styles of chart in technical analysis

There are three main types of chart: line, bar and candlestick. Point and figure charts are occasionally used to trade CFDs, but this type is usually the preserve of highly experienced traders, so most trading platforms don’t feature them.

Easily the most popular type of chart is the candlestick. Candlesticks are almost universally used by traders mainly because they give the most easily readable information about how price has moved over a period. The wide part of a candlestick is the body, showing the difference between the opening and closing prices. In addition to this, candlesticks have wicks at the top and tails at the bottom. These show how price moved in the time between the period’s opening and closing.

Patterns of candlesticks as well as larger patterns of charts are important elements of technical analysis. For more on this broad topic, be sure to follow Exness Education’s insights and join our upcoming webinars.

Adding to charts

 

Trading platforms like MT4 feature a range of built-in technical indicators. These are graphical additions to charts which usually use some sort of mathematical model related to price. Indicators perform a wide variety of different functions depending on how they’re calculated. Nearly every trader uses some type of indicator.

For example, the most popular indicator is the simple moving average (‘SMA’). As its name implies, an SMA displays the average price over a certain period as a line. This indicator can be set to a range of different periods which can make it react more quickly or more slowly to developments in the price itself. SMAs can help to determine trends and momentum in markets among other things.

This example features two SMAs, a 15-day SMA and a 30-day SMA. Both lines function to ‘smooth’ the price and give indications of general direction. The 15 SMA is faster because its calculation involves a smaller number of days. Click on the image to enlarge.

A key signal comes when moving averages cross each other. When a faster moving average crosses above a slower one, this is a ‘golden cross’, a buy signal. On the other hand, the crossing of a faster moving average below a slower one, a ‘death cross’, is a sell signal.

Oscillators and Fibonacci

Oscillators, which usually measure conditions of saturation, are very popular. Saturation can be either overbought or oversold: this means that excessive demand or supply has pushed price beyond what is widely deemed to be justifiable. The stochastic oscillator (usually just called ‘the stochastic’ in the context of trading) is the most common oscillator. It features two ‘trigger zones’ for overbought and oversold. For more information, check out Exness Academy’s article on the stochastic.

Although not strictly a technical indicator, Fibonacci retracement is a crucial tool for many traders. This sequence of numbers in which the next figure is the sum of the previous two forms the basis of percentages of retracement. Lines corresponding to 38.2%, 50%, 61.8% and other retracements are drawn on charts to find points of entry and more. Fibonacci can also help to project possible extensions of movements, also called ‘expansions’ and ‘projections’.

The variety and number of indicators is potentially endless. MT4 has over 30 built in, but you can also design your own custom indicator. Have a look at Exness Education’s insights for examples of how indicators can work in practice.

Support and resistance

 

Support and resistance are areas which function as barriers to movement or to further movement. The first term, support, is an area challenging movement lower. Resistance is a zone that can bar upward movement.

This concept is based on the tendency of prices in financial markets to pause, stop or reverse at certain zones which are somehow significant. The most common determiner of whether an area is important as a support or resistance is whether price has ‘tested’ it and failed to break through.

This means that you can find areas of support and resistance using only the naked eye. However, many traders also use indicators such as slower moving averages, Bollinger Bands, Ichimoku clouds and a wide range of others to find barrier zones.

technical analysis

This example features a resistance on the daily chart of USDCAD, the thick blue line near the top of the chart. Click on the image to enlarge. This resistance represents an area that’s withstood repeated testing. Traders should remember that support and resistance are generally areas, not specific levels. The wicks and tails of candlesticks often briefly break through support and resistance only for price to go back the other way shortly afterward. 

Almost any area of support or resistance is psychological to some extent. That said, traders typically discuss round numbers in the context of psychological areas. Many areas with two or more zeros at the end are important barriers to movement, whether on higher or lower timeframes. For example, most traders would consider 1.00000 on the chart of dollar-franc to be an extremely strong zone of psychological support or resistance even on daily and weekly charts.

Combining methods of analysis

 

Many committed technicians would argue that the price of a security encompasses all of the relevant information available to buyers and sellers, so it’s usually pointless to search for fundamental value. While there is some basis to this belief in various markets, for derivatives it’s not as simple as this.

The fact is that traders of CFDs cannot ignore important fundamental events. Releases of major economic data, interest rates and changes to these, correlations and (perhaps especially) political news all affect markets. This applies for every category of CFD except arguably cryptocurrencies.

Most traders combine TA with fundamental analysis. The advantage of doing this is mainly that they have more information about what’s happening. While TA focusses mainly on price and its history, fundamental analysis concerns itself with the value of an instrument. Understanding how price typically behaves around important news can give short-term traders an edge. Meanwhile, knowledge of the overall direction of a country’s economy can help a trader to project longer term future movements more accurately than TA alone.

Progress in technical analysis

 

TA is probably the most vast and complicated topic that new traders are likely to encounter. It’s unreasonable to expect that you can practise for a few months on a demo account and suddenly become the most brilliant technician ever. Instead, you should be patient and commit to keeping it simple at first. After you’ve grasped the essentials of TA, you can move on to integrate more techniques into your strategy.

Ultimately, the key to successful technical analysis is to avoid excessive focus on predicting the future. Instead, traders should pay attention to current trends. These usually leave clues as to where price might go. It’s essential to remember that you needn’t enter at the very start of a trend or exit at the very end to make a profit.

The next key article of Exness Academy’s cornerstone content is on fundamental analysis. Check it out to learn more about how the two main types of analysis can be combined.

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